Preference Payments and The Untouchables

Executory Privilege

As many vendors are aware, perhaps the most disappointing
aspect of bankruptcy law is being slapped with a preference lawsuit.
Often times, vendors find it difficult to get paid at all, let alone
receive a payment, and then defend it in a costly preference action.
Moreover, a preference action seeks a dollar for dollar return to
the estate whereas a vendor only receives a pro rata distribution under
bankruptcy.

Accordingly, many of these vendors will defend the
action with one of several codified exceptions to the preference
action; others will control their destiny and reach settlement on
terms that may be more favorable than treatment under a plan. However,
certain vendors will keep their preference payment in their pockets
despite the efforts for recovery of the payment by a preference
plaintiff. These vendors are the "Untouchables."

The Untouchables are vendors that hold executory contracts
and unexpired leases (hereinafter "executory contracts").
An executory contract is a contract under which the obligation of
both the bankrupt and contracting party is so far underperformed
that the failure of either to complete performance would constitute
a material breach, and thus, excuse the performance of the other.

As a matter of law, transfers made during the preference
period are not recoverable if the payments were made pursuant to
an executory contract that was assumed by the trustee.1 This conclusion
finds support in case law and the application of section 547 and
365 of the Bankruptcy Code (the "Code"). Therefore, it
is essential for these vendors to demonstrate the importance of
their executory contract and convince the trustee that assumption
of the contract will further its efforts to reorganize.

Recovering Transfers During The Preference Period
The requirements of section 547(b) are designed to encourage an equitable distribution
among similarly situated vendors.2 Accordingly, section 547(b) provides that
a trustee may avoid any transfer in property of the debtor if the transfer
meets five requirements.3 The preference period is 90 days prior to the filing
of the petition, but may extend to one year if the transferee is an insider.

If the trustee satisfies the requirements of section
547(b), then the transfer is recoverable unless the transferee can
prove that an exception is available. Generally, the exceptions
are codified, however, many vendors are surprised to learn that
exceptions are also generated from the interaction of certain Code
provisions.

Curing Defaults As A Prerequisite To Assuming An Executory
Contract
The purpose of section 365 is to allow a trustee to reject burdensome executory
contracts, while at the same time, provide the trustee with a mechanism to
force others to continue to do business with the debtor during its reorganization.4

Accordingly, section 365(A) states that a trustee
may assume an executory contract, provided that, "if there
has been a default . . . the trustee may not assume such contract
. . . unless, at the time of the assumption of such contract, the
trustee . . . cures, or provides adequate assurance that the trustee
will promptly cure, such default."5

If the court grants a trustee's assumption of the
contract, the contracting party has no choice; continued performance
is required under the terms of the contract.6 However, if the debtor
is delinquent under the executory contract, either prepetition and/or
postpetition, then the trustee must demonstrate to the court that
he can cure the default and make future payments.

Accordingly, an assumption order distinguishes the
contracting party from other vendors. The contracting party is forced
to continue to do business with the debtor. However, in exchange,
the contracting party is entitled to payment of all amounts due
under the contract. In other words, the assumption effectively gives
the contracting party a secured interest in monies due, and effectively,
eliminates preference actions.

Creating A Common Law Exception:
To Cure or be Cured
Viewed separately, section 547(b) and 365 appear mutually exclusive and do
not pose any inconsistencies. However, the treatment of any transfers made
during the preference period will depend on whether the trustee elects to assume
or reject the contract. If the trustee assumes the contract pursuant to section
365, then section 547(b)(5), a requisite to recovery of a preferential transfer,
will not be satisfied and no preference is deemed to have occurred.7 It is
common sense.

The requisite to assuming an executory contract is
to cure the prepetition default, and the payments received during
the preference period would have to be paid under a cure. If these
payments were recoverable as a preference, then the trustee would
have to repay the preference to assume the contract. The result
is a wash.

As further protection against an enthusiastic trustee,
the equities of assumption cannot be made in a preference action,
but must be made in an action challenging the order that approved
the assumption. Courts have applied the doctrine of estoppel to
preclude the trustee from receiving the benefits of an assumed contract
without also assuming its obligations.8

Additionally, the congressional intent behind section
365 is decisive; a party to an executory contract must be paid all
amounts due under the contract before the contract may be assumed.
In drafting section 365(b)(1), Congress ensured that a contracting
party is made whole before a court can force the party to continue
performing with a bankrupt debtor, "[i]f the trustee is to
assume a contract . . . the court will have to insure that the trustee's
performance under the contract . . . gives the other contracting
party the full benefit of his bargain."9

By retaining prepetition payments, a party to an assumed
contract does not receive more than other similarly situated vendors.10
From the moment that the assumption order is entered, the contracting
party's interest is necessarily distinct from the interests of unsecured
vendors. Permitting a preference suit after an assumption order
would undermine the purpose and intent of section 365. Accordingly,
the assumption of an executory contract bars recovery of a preference
claim.

Seminal Cases
In Superior Toy, the Seventh Circuit dismissed a preference action commenced
against a party to an assumed contract.11 The court ruled that the cure provisions
of section 365 required the trustee to cure all prepetition defaults prior
to assuming the contract, and therefore, the payments during the preference
period were not preferential. The court ruled that preference actions are prohibited
against parties to an assumed executory contract because section 365(b) requires
a trustee to cure all defaults of an assumed contract. The Seventh Circuit
also concluded that the trustee was estopped from prevailing on the preference
action as the trustee benefited under the assumed contract. See Id. at 1176.

In In re LCO Enterprises I, the Ninth Circuit
considered whether a trustee is entitled to recapture prepetition
lease payments as a preference where the trustee assumed the lease.12
The court's inquiry was the appropriate classification of the vendor.
In the ordinary case, general unsecured vendors claims are fixed
at the date of the bankruptcy petition and preferential transfers
are subject to recapture.

However, vendors holding executory contracts and unexpired
leases stand in a different position relative to general unsecured
vendors. Although the prepetition default may be fixed, the status
to the right to payment from the estate is not fixed because it
is dependent upon whether the trustee assumes or rejects the executory
contract or unexpired lease. If the trustee assumes the contract
pursuant to section 365, then section 547(b)(5), a requisite to
recovery of a preferential transfer, will not be satisfied and no
preference is deemed to have occurred.

After distinguishing the holders of general unsecured
claims from those vendors that are parties to an executory contract
or unexpired lease, the Ninth Circuit considered the application
of the hypothetical chapter 7 case under section 547(b)(5). The
Ninth Circuit aligned the interests of party to an assumed contract
or lease with that of a secured vendor.

These vendors would be entitled to prepetition payment
of their claims. Accordingly, the Ninth Circuit concluded that,
taking the facts as they are at the time of the assumption, the
holder of an assumed contract or unexpired lease is entitled to
100% of the claim. The preference action was dismissed.

Other Code Provisions
In Seidle, the Eleventh Circuit considered whether a trustee is entitled to
recapture prepetition contract payments when the parties entered into a court
approved stipulation pursuant to section 1110.13 Under section 1110, a debtor
may retain possession of equipment by curing defaults and making the required
payments. The Eleventh Circuit concluded that a trustee is precluded as a
matter of law from bringing a preference suit after the court approved the
stipulation.

"A trustee's election to set aside alleged preferential
payments would undermine the protection that section 1110 provides
for vendors. Pursuant to the section 1110 stipulation, a vendor
is entitled to unpaid prepetition payments, as defaults; a trustee
may not later thwart the effect of the statute by challenging the
validity of these transfers as preferences."14

Conclusions
If you are a vendor to an executory contract or unexpired lease, then carefully
assess your situation. If you are exposed to a substantial preference action,
then getting the trustee to assume your contract is key to eliminating your
liability. The exchange, of course, is a continued relationship with the
debtor throughout the term of the contract. However, if you are a vendor
with an assumed contract that has already encountered a preference action,
then do not give in to the trustee as you may be a member of the Untouchables.

1 The court may require the consent of the contracting
party when the trustee intends to assign the contract to a third
party. See In re Catapault Entertainment, Inc., 165 F.3d
747 (9th Cir. 1999)(holding that federal patent law constitutes "applicable
law" within meaning of Bankruptcy Code provision barring debtor
from assuming executory contract without nondebtor's consent where
applicable law precludes assignment of contract to a third party).

3 Under § 547 (b), a trustee or debtor may avoid
any transfer of an interest of the debtor in property if the transfer
is: (1) to or for the benefit of the vendor; (2) for or on account
of an antecedent debt owed by the debtor before such transfer was
made; (3) made while the debtor was insolvent; (4) made - (A) on
or within 90 days before the date of the filing of the petition;
or (B) between ninety days and one year before the date of the filing
of the petition, if such vendor at the time of such transfer was
an insider; and (5) that enables such vendor to receive more than
such vendor would receive if -(A) the case were a case under chapter
7 of this title; (B) the transfer had not been made; and (C) such
vendor received payment of such debt to the extent provided by the
provisions of this title. See 11 U.S.C. § 547 (b).